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Is The Evidence For An Apple Margin Collapse Now Incontrovertible?

My many warnings on the impending dethroning of Apple by Google has produced more flak and negative response since any proclamation since my warning about Goldman Sachs in the spring of 2008. Of course, fast foward to the spring of 2011 an you will find Reggie was right on point. I am just as confident, or more, about Apple vs Google, and for the same reasons as I was confident about Goldman Sachs. You see, its not about the quality of the company. Both are strong American companies with strong management, but both are (or at least in the case of one of them, "were") also seen as iconic to such a degree that investors and customers failed to look at the actual numbers, outlook and underlying trends beneath said iconic, "spit-shined-to-perfection-through-marketing" patina. Remember, don't look to BoomBustBlog for what you want to hear, look to us for what you need to hear. With that being said, we have released our valuation numbers for Apple to Subscribers (Pro/institutional level subscribers may contact me directly about the analysis) and the reviews of the latest credible competition to Apple's fastest selling products are now out - the Samsung Galaxy Tab 10.1 (Samsung's reworked answer to the iPad) is now taking pre-orders, and the reviews are very positive.

Engadget's Darren Murph: It's quick, nimble, and easy to hold, and it's both thinner and lighter than the heralded iPad 2. There's no question that we prefer the handling of the Tab 10.1 over Apple's alternative, and with the improvements coming with Android 3.1 (and in time, Ice Cream Sandwich), it's going to be mighty hard to overlook this device come June 8th. The 16GB WiFi model will hit for $499 -- exactly in line with the iPad... There's just no other way to say it: the iPad 2 finally has a real competitor. If Samsung could somehow undercut Apple by even $25 here, the choice would be obvious, but it's going to have a whale of a time convincing the masses that a Samsung device is superior to one Designed in California when prices are equal. That said, we'd still recommend the Tab 10.1 over the iPad 2 for heavy Gmail users and all-around fans of Android."

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There are several other reviews around, but Endgadget is, by far, one of the most objective, least unbiased reviewers popularly available. Examples of bias were evident when the reviewer would list how the Samsung pre-release product was faster, shot better pictures, had a better screen, was slimmer, lighter etc., yet in the conclusion states that they prefer the iPad 2 over the Samsung because it is "sexiest", but considers the Samsung the "iPad 2" of Android world. At least from our perspective, this strays from a straightforward comparison, but does exemplify the results of Apple's superior marketing capabilities which should serve it quite well as competition is rapidly ramping up.

As a refresher, here are reviews for the Asus Transformer priced at 80% of the cheapest iPad:

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The Asus Eee Pad Transformer has been a very popular tablet - even topping Amazon's best selling tablet list - for two main reasons. Firstly, it provides great value for money; it is both cheaper than the iPad 2 and has a bigger screen with a better display resolution.

The release of the Samsung tab 10.1 marks roughly 1% of the Android Honeycomb tablets slated to be released in the next year (4 - Xoom, G-Slate, Iconia Tab, Asus Eee Pad Transformer - out of about 400), and look where we are already. This is going to be a much tougher fight for Apple than even that of the smartphone market, and you see how well Android did in that category as the current market leader in both footprint and growth rate. Literally98% more competition is coming down the pike this year, and products are already widely reviewed as at parity or superior in Apple's chief diversification segment (remember, derives ~70% of its profits from the iPhone). With that, even the iPhone is supremely challenged by Apple's own parts vendors, Reference Looking at the Results of Google’s “Negative Cost” Business Model Employed Through Android:

Apple's biggest suppliers (the most important parts vendors for the products that contributes about 75% of Apple's profits) and the companies that Apples is currently embroiled in global litigation with (no wonder why) also produce similar products, ex. the LG Optimus 3D and the Samsung Galaxy S II.

Speaking of the Samsung Galaxy, this newest refresh is nearly universally thought of to be the best smartphone available, including the Apple iPhone. I haven't found a single review yet that has said otherwise. This is an impressive feat considering how "Apple-centric" the media currently is. Reference this snippet from Endgadget:

For a handset with such a broad range of standout features and specs, the Galaxy S II is remarkably easy to summarize. It's the best Android smartphone yet, but more importantly, it might well be the best smartphone, period. Of course, a 4.3-inch screen size won't suit everyone, no matter how stupendously thin the device that carries it may be, and we also can't say for sure that the Galaxy S II would justify a long-term iOS user foresaking his investment into one ecosystem and making the leap to another. Nonetheless, if you're asking us what smartphone to buy today, unconstrained by such externalities, the Galaxy S II would be the clear choice. Sometimes it's just as simple as that.

Endgadget is not the only reviewer to go head over heals over Android super-powered phones. Check it out, courtesy of onlinesocialmedia.net:

Dan Sung of Pocket-Lint rates the phone with 4.5 out of 5 stars and calls it a “cracking experience” and like Engadget, “better than any other Android smartphone.” Very minor complaints included the 1080p DLNA streaming, which was noted could be better, plus minor quibbles with the camera lens but overall the conclusion is that “no one buying this superphone will have anything to complain about.”

Chris Davies over on Slash Gear. Guess what, Davies also says, “this could well be the best Android smartphone on the market today” and noted that iPhone users that were shown the Galaxy S II said they could have their heads turned by it. There were minor criticisms, such as the keyboard, but these were said to “pale in comparison to the Samsung’s strengths.” In conclusion Davies says “we’re running out of reasons not to buy the Galaxy S II.”

Electric Pig by Ben Sillis, who gave the phone a staggering 5 out of 5 star rating and says “Samsung has triumphed again with theSamsung Galaxy S 2.” There are some quibbles about software in this review but not enough to get in the way of it being a “surefire contender for phone of the year,” and again the superb display gets a special mention.

Be aware that Samsung builds the chips for Apple's iPad and iPhones, is embroiled in a 4 or 5 country IP lawsuit with Apple, and also happens to build their own proprietary chip for the phone above and most likely the chips for their new (thinner, faster, lighter and possibly less expensive) tablets as well. It appears as if the stuff they build for their own Apple-competing products are cheaper and faster than what they produce for Apple. This puts Apple in a bind as they not only compete directly and sue Samsung, but will have a problem as they cannot quickly jump to another vendor that can produce the volume and tech that Samsung does. What happens when your biggest and most valuable vendor becomes your biggest biggest competitor and you start suing them? What happens when they produce superior tech for their own competing products? Well, we're about to find out. We may also find out what happens when your second largest and most valuable supplier does the same, for LG is going full steam ahead with high end Android tablets and phones as well, supplying equal or superior screens for their devices as well.

Obliterating the thesis that Apple has superior pricing power, Samsung has come out with a competing tablet with a better screen, that is lighter and thinner than the iPad 2, running superior cameras - all for the same same price point (see reviews above). Asus, the inventor of the netbook category which prompted Apple to reinvent the tablet computer in the first place) has come out with a tablet featuring a better screen, a different (and in our opinion, as well as others) superior add-on form factor (keyboard dock) that enables production of content as well as mere consumption of content, and comparable performance for a full 20% less than Apple's entry level product! Reference New Taiwanese Tablets Show What So Few Have Suspected: Apple’s iPad 2 Is An Expensive Toy!

As explained in the last article on this topic, Apple is not lacking for demand in tablets but is truly lacking for supply. The Japanese Tsunami/nuclear disaster has curtailed supply and Apple is also forced to fight (literally, as in through global law suits) with it's major suppliers for its most profitable products as direct competitors in the tablet and smartphone space. Thus, whatever remaining supply that Apple previously negotiated as the sole large volume buyer is now hotly contested by nearly every large computer and media device manufacturer in the world. We called this occurrence last summer, and it is now becoming apparent as Apple strains to retain costs (ie save margins) while simultaneously swapping inferior components. As excerpted from New Taiwanese Tablets Show What So Few Have Suspected: Apple’s iPad 2 Is An Expensive Toy!

Not only is competition expected to put significant pressure on prospective demand, it is driving costs up as well. The following is excerpted from the subscriber document Apple - Competition and Cost Structure.

While Apple's battle with Samsung has made the most headlines in the pop media, it's there competition with LG Electronics that is really hurting them from a line item perspective. As practically every new Honeycomb tablet (except for the first, the Mororala Xoom) features a superior screen at a comparable (or in the case of the Asus Transformer, much lower price), the cost of said components are not only the largest line item cost for Apple, but the largest expense increase over generation as well. Apple will be very hard pressed to find a vendor who can supply in the volume and quality that LG Display can (giving them ample pricing power), and if it were to shop around it will probably have to solicit... Samsung, it's largest competitor in the tablet/smartphone space, via Android.

65.8 million people in the U.S. owned smartphones during the three months ending in January 2011, up 8 percent from the preceding three-month period. Google Android captured the #1 ranking among smartphone platforms for the first time in January with 31.2 percent market share. RIM ranked second with 30.4 percent market share, followed by Apple with 24.7 percent. Microsoft (8.0 percent) and Palm (3.2 percent) rounded out the top five.

With all of the evidence introduced above, our original thesis is stronger than ever. We never called for the fall of Apple, but definitely did call for the fall of Apple's margins - which is, as we see it, a given. With the extreme emotional sentiment directed at Apple, this proposed margin fall may very well be faced with outsized reaction from the market - you know, as if the impossible has actually occurred.

No, Google is not in the mobile space for search ads, it's looking to become the next Microsoft with Android as the next Windows. It is thinking big, simultaneously going after both the consumer and the enterprise space with cloud-based software and services - and advertising!

In the meantime, sheeple-like investors are being hoodwinked by quarter after quarter of Apple blow out earnings. Don't get me wrong. I feel and fully acknowledge that Apple is executing on all 8 cylinders of a 6 cylinder engine, but it still has its real world limitations. Apple will start to bump up against these limitation over the next 4 quarters, and the signs of this bump are already apparent. Of course, the signs are being handily masked by the games that Apple management and the sell side analysts of Wall Street play, with the "Sheeple" retail and the lazier component of the institutional investors being put out to take the eventual bullet.

Riddle me this - If Apple can consistently beat the estimates of your favorite analysts quarter after quarter, after quarter - for 11 quarters straight, shouldn't you fire said analysts for incompetency in lieu of celebrating Apple's ability to surprise? After all, it is no longer a surprise after the 11th consecutive occurrence, is it? I would be surprised if my readers were surprised by an Apple surprise. Seriously! Apple management consistently lowballs guidance to such an extent that it can easily manage, no - actually create outperformance. This has has a very positive effect on their valuation. Of course, I do not blame Apple management for this, of they are charged with maximizing shareholder return. The analytical community and the (sheeple) investors which they serve is another matter though. Subscribers can download the data that shows the blatant game being played between Apple and the Sell Side here: Apple Earnings Guidance Analysis. Those who need to subscribe can do so here.

Below, I drilled down on the date and used a percentage difference view to illustrate the improvement in P/E stemming from the earnings beats.

In our analysis of Apple, we are using real world assumptions of future performance derived from backing in to the low balling this company is prone to. If you look at its history carefully you can gauge what management is comfortable with, hence what they may be capable of on the margin. Using these more realistic numbers, it is much more likely Apple will deliver a miss in the upcoming quarters in its battle with the Android! The following is the reason why...

Next up in the technology space: Google valuation adjustments in our proprietary valuation model for professional/institutional subscribers re: Chromium/Android (see Google Valuation Model (pro and institutional)) and how Chrome netbooks and Android tabets (ex. the Transformer) can (and probably will) curtail Apple's move into the enterprise in next article.

5 comments

Reggie, great stuff as usual, both from a technology perspective and in thinking about valuations. It seems you would be short almost all tech companies right now, with the possible exception of Samsung. Are there any tech companies you like as equity investments now??? (I mean ones you would go LONG on). Also GS has been beaten down quite a bit. Is it fair value around 135??? I'm guessing you will direct me to subscription, if so fair enough, but I have to wrangle as much free stuff out of you as I can Reggie, you understand eh???

Reggie, I am concerned your Apple bias is causing you to miss some key points .
(1) iPad revenue includes high margin items like the smart cover, chargers/docks. The competition has none of these
(2) Apple sells the bulk of iPads in their stores and online store and don't have to give up as much money to the retailers like best buy etc.
(3) Selling a competing product even with better specs for the same price as the iPad is not competing with the iPad given the factors above.

Apple is able to get much better pricing on components that any single competing vendor.